Welcome to our active management update on the market
I have recently received a number of questions regarding tax efficiency (for nonqualified accounts) as it relates to our active approach to portfolio management. I use the following example (see graph) to help explain this issue. I start with the widely known capital markets line, which illustrates that rate of return generally goes up as risk goes up. The same can also be said about tax efficiency of an investment methodology. Think about that for a second. Most tax-efficient portfolio-management strategies (think “buy and hold”) change portfolio holdings less often than other strategies. That means that those portfolios respond to changing market conditions less often. As a result, those portfolios tend to be susceptible to more market risk.
Of course, the converse is also generally true. The less tax efficient a strategy/portfolio is, the less risk it is generally susceptible to and, therefore, likely to experience. As with rate of return versus risk, tax efficiency versus risk is also a trade-off. Investors and their financial advisors should address this when discussing strategies and resulting portfolios to help set appropriate expectations.
What also needs to be present in that discussion is a frank conversation about risk tolerance. Investors’ risk profiles on paper may be different from their risk profiles in personality. So, before crafting any investment solutions, take the time to dive deeper into the risk conversation.
While on the topic of crafting solutions, remember to use the many resources at your disposal to create appropriate solutions. Avoid looking solely at long-term return and max loss. This can be quite deceptive because some strategies have back-end-loaded returns. This means that some strategy returns were large for a number of years many years ago and not so impressive in the most recent four or five years. This is not necessarily a bad thing, but it is important to know when discussing how and when strategies may and may not perform.
Also, pay attention to the way portfolios perform year by year over time. Some portfolios have quite irregular returns—posting large gains in one- or two-year periods followed by several years of low returns. Other portfolio solutions may achieve the same return-to-risk profile but in a more consistent fashion. The end result may be similar, but the journey experienced by the investor may be more desirable.
One last note: I wrote a piece for the ETF newsletter Invest With An Edge on the use of environmental, social, and governance (ESG) screening in funds used in our For A Better World strategies. If you are interested in investing solutions that may help you “do well while doing good,” take a few moments to give it a read.
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